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Chief Investment Officer's team, 20.01.2020
Geopolitical tensions between the US and Iran fuelled volatility in the first trading days of the year, but last week, geopolitical relief between the US and China contributed to support investors’ appetite for risk. The first hints at the concept of a “Phase 1” trade deal appeared back in November, and as often, the anticipation moved markets more than the actual signature, which happened last Wednesday. The idea that trade tensions peaked last year and that the global economy should recover in 2020 also gained traction after China released its GDP numbers for Q4. At 6% annualized, the growth was in line with expectations and the government’s guidance, but more importantly, monthly data surprised on the upside on both retail sales and industrial production. At the same time, the earnings season started in the US, with overall positive results. This was enough to push equities 1% higher on average, with a new record for the S&P500. US rates were marginally higher, capping government bonds, but the riskiest segments of Fixed Income did well. Within the asset class, we added 1% across our profiles to Emerging Market debt, funded by a reduction in DM corporate debt, as we see the risk/reward as better. We are overweight in both Emerging Markets equity and debt.
The week ahead will be dominated by the US on two fronts: the corporate earnings, as well as the Presidential impeachment trial starting at the Senate. We are fully invested, but as we expect single-digit returns this year, we watch closely for any sign of excessive optimism.
In an interesting speech recently delivered in Washington Ms Georgieva, Senior economist at the International Monetary Fund, may have had more than one in the audience startle in their seats when she said that some of today’s socioeconomic trends are reminiscent of the period preceding the Great Depression of the 1930s. In particular, she was referring to the relentlessly rising inequality across the OECD countries, which has already seen the resurfacing of populism in the search for a quick fix to long-standing issues.
While she offered a carrot and a stick at the same time, flashing a warning and suggesting some remedies, in our view one important aspect of her speech is that fiscal policies are amongst the “critical tools” governments tend to resort to firstly for the purpose of addressing inequality. This ties in with the growing awareness that nowadays monetary policy is exhausted and must pass the baton to fiscal remedies fostering aggregate demand. So, although using the monetary lever still seems to be the only game in town, the next forthcoming game will be a different one, as excessive liquidity creates financial instability and the existing long-standing socioeconomic issues will force a change in any case.
This has consequences from an asset allocation point of view. Indeed, the well-know 60/40 portfolio, often advocated as a simple, yet effective benchmark allocation tool with diversification features, is after all a monetary portfolio. It has perfectly worked across recent decades, delivering low double-digit returns, only because the monetary-induced economic regime, of higher growth and lower interest rates alongside falling inflation, is what has boosted both equities and bonds.
What if the regime changes to one of higher inflation and lower growth or one of muted growth and rising inflation? Indeed, inflation would be a consequence of fiscal policy. While monetary tools tend to affect financial assets instantaneously, have a lagged effect on the economy and haven’t generated price pressures, fiscal measures work the other way around by enhancing the purchasing power of economic agents instantaneously, increasing inflation in the process and impacting markets only with a delay. The latter is accounted for by fiscal measures boosting the overall equilibrium rate, hence bond yields, at first a negative factor for markets rather than a supportive one.
A simple portfolio more balanced in terms of its responsiveness to different macroeconomic regimes, which has offered competitive risk-adjusted returns, is the so-called ‘Permanent Portfolio’, proposed by the US investment analyst Harry Browne in the 80s. It is built out of equal allocations to equities, bonds, gold and cash. The last two assets have historically performed well under conditions of inflationary rates rising faster than real growth rates, most unfavorable for the typical 60/40 allocation. To conclude, long-term investors be warned if you are entertaining the idea of keeping your asset allocation unchanged for the next decade.
Fixed Income Update
After a volatile start to the year, last week came as a sigh of relief to most bond investors. Most of the benchmark sovereign yields were range-bound except for UK Gilts fueled by a high probability of a rate cut by the Bank of England during its January meeting. The benchmark 10-year UK Gilt was yielding 0.632% down 13 bps in a week. MOVE Index, which indicates volatility in the treasury yields and by extension, the global bond market, was trading at its lowest point since May 2019.
In a significant announcement last Thursday, the US Department of Treasuries said that they would start issuing 20-year bonds during the first half of 2020. 20-year bonds were last introduced in 1981 and stopped five years later. The federal budget deficit topped USD 1 Trillion for the first time last year post-2012 and is expected to be around USD 1.2 Trillion this year.
ECB is set to announce its first strategy review since 2003. Economists widely anticipate ECB to adjust its inflation targets and the expectations range from more precise inflation targets to having the flexibility to overshoot/ undershoot the absolute goal.
January marks a busy month for EM Central Banks with several showcasing some easing policies while some EM nations move into negative real rates. The Central Bank of Turkey lowered its one-week repo rate by 75bps to 11.25% and joined the negative Real-rate regimes across the world. The CBT cited, "At this point, the current monetary policy stance remains consistent with the projected disinflation path." Benchmark short-dated bond yields fell below the 10% mark while the ten-year benchmark closed at 10.71%, resulting in a flattening of the TRY yield curve. Moreover, The Central Bank of Egypt maintained key rates unchanged. The consensus was tilted towards a 100bp cut on the back of the steep real yield, followed by the trends of a strengthening EGP during the last twelve months.
Chinese property sector bond issuers contributed to 45% of total dollar debt issued in so far this year. It raises concerns about concentration risk, especially in the HY space where issuers from the sector accounted for 88% of total issuance YTD 2020.
Kuwait Projects' outlook was downgraded to negative from stable while the Baa3 credit ratings were affirmed by Moody's. The agency cited, "the negative outlook reflects that market-based leverage (MVL) will remain above Moody's downward rating guidance of less than 25%. Despite the KD95.1 million ($313.6 million) equity raised in July 2019, MVL stood at around 31% as of 31 December 2019. This is also the result of the slow progress made in turning around Orbit Showtime Network (OSN)’s financial performance since November 2018, which remains unprofitable and has required financial support".
A de-escalation in Middle East tensions led to a pick-up in GCC equity markets. UAE equity indices ended the week up over +2% and the KSA index had a good week too at +1.4%. Real estate stocks in the UAE rose as investors are building up expectations of robust dividend payouts, and as there is news that long term visas are a possibility for more than just large expat investors. The surge in UAEs real estate supply over the past few years in both commercial and residential infrastructure needs a stickier and growing population and a pick-up in economic activity. The Expo 2020 promises the boost to economic growth, with an expected 25 million visitors.
US equity indices (+2% for the S&P 500 for the week) set new highs last week, along with a rally in Asian stocks supported by data on strong American consumer demand and an improving Chinese economy. China’s economy stabilized last quarter after slowing to the weakest pace in almost three decades, with the first acceleration in investment since June signaling that a firmer recovery could be underway. GDP rose 6% in the final quarter of 2019 from a year earlier, and Chinese industrial output topped estimates. Technology continues its lead (+5.5% YTD), and Alphabet’s market valuation hit $1 trillion, joining Apple and Microsoft.
We are in an overbought condition for the S&P 500, with valuations more than a standard deviation above long-term median levels, but clearance of trade risks and better-than-expected earnings results could keep the index supported near term. Fiscal overhauls with tax savings at the six biggest US banks aided robust bank earnings, with savings over the last two years at $32 bn (Bloomberg), as the average effective tax rate fell to 18% from 30%. Consumer credit remains the key growth driver for the economy and for the continuation of the market rally, and so far that's supportive. JP Morgan reported that consumers spent 10% more on their cards in the fourth quarter than the prior year, and Citigroup said consumers spent 5% more and both banks also said the consumer balances were higher. In their earnings call JP Morgan stated that “The consumer was strong and confident throughout the season". The US economy seems to be in good shape. Data on housing revealed that construction of new US homes rose in December to the highest level since 2006.
Jeff Bezos trip to India was fraught with controversy as Amazon faces an antitrust probe and there were protests from local traders. Amazon also has to take on the might of Reliance’s Jio Mart, which is focused on promoting the products of small retailers. Reliance Chairman, Ambani’s ambition is to link up 30 million neighbourhood stores to the 360 million-plus customers of its 4G telecom network, Jio and dominate grocery and fast-moving consumer goods by offering discounts, cashless payments, in-store credit and the convenience of home delivery. Whilst China has been closed to the large Western tech firms, India has allowed entry, but on its own terms. Amazon has already committed $ 6.5bn to India with another $ 1bn committed last week when Bezos visited.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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A geopolitical start to 2020
A fantastic 2019, a volatile start to 2020
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